The current economic environment in the U.S., with sluggish economic recovery, slow growth of the labor market and cautious consumers, seems ripe for the growth of dollar stores. Despite the favorable business environment, Family Dollar (FDO) continues to struggle. The store has disappointed its investors with an earnings miss and a significant cut in its guidance. Moreover, the COO’s exit has further exacerbated the situation.

The company’s shareholders did get some support from Credit Suisse in which the bank suggested that Wal-Mart (WMT) should consider acquiring Family Dollar. This would give a significant boost to Wal-Mart’s efforts to expand its small stores. As a result, Family Dollar’s shares rose 1.7% on Wednesday.

Earnings Miss

In its previous quarterly results which included the holiday season, Family Dollar ended up giving more discounts to customers than it had originally planned.

Although the company’s quarterly sales rose 3.2% to $2.50 billion, its net income dropped 2.8% to $78 million, or $0.68 per share. Family Dollar missed both revenue and earnings estimates by $10 million and $0.01 per share, respectively.

The company showed strongest performance in the consumables category, which accounts for 75% of its quarterly sales. In this segment, Family Dollar witnessed a 4.7% sequential growth in sales. However, this growth was driven largely by low margin products. Therefore, the company’s income dropped, despite an increase in revenues.

Category

1Q13 Sales (Million)

1Q14 Sales (Million)

% Change

Consumable

$1,789

$1,873

4.7%

Home Products

$242

$240

-0.8%

Apparel and Accessories

$178

$172

-3.4%

Seasonal and Electronics

$212

$215

1.4%

Moreover, Family Dollar has announced that its president and chief operating officer, Michael Bloom, has resigned. Family Dollar has been implementing some significant changes, which include management overhaul, store renovations and expansion of replenished items. The loss of Michael Bloom is disappointing as he was responsible for carrying out some of these key changes.

Margin Pressure

An increase in sales of lower margin products, coupled with a fall in sales of higher margin discretionary items and an increase in inventory shrinkage is putting a lot of pressure on the company’s margins. Fortunately, Family Dollar benefited from higher markup and lower freight charges. Therefore, the company managed to improve its gross profit margins by 20 basis points from the same quarter last year to 34.3%.

Historically, in terms of gross margins, Family Dollar has been behind Dollar Tree (DLTR), but has remained ahead of Dollar General (DG). Over the last five years, Dollar Tree’s margin has hovered in the mid-to-high 30s, ahead of Family Dollar that floats around the mid-30s and Dollar General, which remains in the low 30s.

Falling Comparable Sales

What is particularly alarming is Family Dollar’s declining trend in its comparable store sales. The company reported a 2.9% gain in comparable sales in second quarter 2013 and another 2.9% gain in third quarter 2013, flat comparable sales in fourth quarter 2013 and finally a decline of 2.8% in the previous quarter. This was largely due to the intensive promotional environment during the quarter.

On other hand, Dollar General witnessed an increase in traffic and improvement in average transactions in its previous quarter. This drove a 4.4% increase in the company’s comparable store sales. Unlike Family Dollar, Dollar General reported a 1.5% increase in net sales rose and an impressive 14% increase in profit from last year. As a result, the company ended up beating the earnings estimates.

Similarly, Dollar Tree also performed better than Family Dollar with a 3.1% increase in comparable store sales, a 9.5% increase in net sales and a by 13.7% increase in profits from the same quarter last year. However, Dollar Tree’s fiscal year 2013 guidance for revenues and earnings was below analysts’ estimates.

Meanwhile, Family Dollar’s problems with the comparable store sales will continue. In its guidance, the company has forecast another decline in its comparable store sales for the current quarter. Family Dollar is now expecting its comparable store sales to fall “in the low-single-digit range.” Earnings per share are expected to be between $0.85 and $0.95 per share, which will be a significant decline from $1.21 per share in the corresponding quarter of 2013.

It should be noted that the comparable quarter of last year includes an extra week, which added $189 million to revenues and $0.07 per share to earnings.

For the full year, Family Dollar has significantly lowered its earnings guidance to between $3.25 and $3.55 per share from between $3.80 and $4.15 per share.

Conclusion

For the current quarter, analysts’ expectations are already pretty low. According to data compiled by Thomson Reuters, for the current quarter, analysts have a consensus revenue estimate of $2.77 billion and earnings of $0.91 per share. If Family Dollar manages to touch these estimates, then it would report a 4% drop in revenues and a 21% drop in earnings from the same quarter of 2013.

Its shares are currently hovering around $65.70, which implies a price-to-earnings ratio of just 17.20 and price-to-trailing-sales ratio of just 0.7. By these metrics, the stock is not expensive as most of the players in this industry have a much higher price-to-earnings and price-to-trailing-sales ratio. Family Dollar is cheap for a reason.

It has not impressed with its performance and will likely continue to suffer in the medium term. Its stock has been up lately but it is largely due to the speculation related to Wall-Mart’s acquisition, which seems extremely unlikely.

Disclosure: This article was written by Sarfaraz A. Khan, with valuable contribution from Gohar Yousuf, research assistant at Half Bridge Business Review. Neither Sarfaraz A. Khan, nor Gohar Yousuf have any positions in the stock(s) mentioned in this article.

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